Wednesday, March 9, 2016

Based on my Twitter feed, stock buybacks seem broadly misunderstood in terms of what they are meant to accomplish (to redistribute excess capital back to shareholders) and the impact they have relative to dividends. As an aside, I also don't understand the following typical complaints:

Buybacks are done when stocks are rich: if the stock of a company performing buybacks is "rich", then why are you owning it to begin with?

Buybacks are often done during bull markets and stop during bear markets: that is due to the fact companies often have higher earnings and more excess cash available to distribute during bull markets

As a result, I wasn't too surprised when the below chart made the rounds yesterday, along with the following implications:

Buybacks are an incremental driver of the outflows we've seen from households

Why flows (both inflows and outflows) do not relate to demand / why households almost always have outflows

Buybacks and Dividends are Economically Identical
Excluding the potential signaling or tax effects of buybacks vs dividends, buybacks and dividends are identical in terms of overall economic impact. For example, assuming the following:

Corporation X has $2.5 billion in excess cash to distribute back to shareholders

* In the buyback scenario, $2.5 billion is bought back by Company X, but if all shareholders acted like Shareholder X, they would sell $1 billion for their spending needs ($1.5 billion net purchases); in the case of dividends, of the $2.5 billion distributed, $1 billion is spent, and the same $1.5 billion is used to buy back shares with the excess cash.

Household Flows Don't Matter / Should be Negative

As highlighted above under 'what has changed', household outflows are in fact impacted on the margin by the form of capital distribution (i.e. whether it is received via buyback or dividend). In the case of a buyback, households are simply creating their own dividend through the sale of shares. Given the two situations are identical in terms of overall demand for Company X stock (demand at time 0 was $5000 worth of stock, post spending it was $4000), we can see why flows really don't matter.

In fact, while the initial chart circulating through Twitter highlights the negative flows from the household sector for stocks from 2008-2015, what may be a surprise is that the overall level of stocks held by the household sector (i.e. a better measure of demand) jumped from $5.4 trillion at the end of 2008 to more than $12.7 trillion over that same time frame (as of 9/30/15 - the latest z.1 report), a normalized increase of 37% of GDP to 70% of GDP.

But a key point is that household net flows for a mature / functioning economy should be negative... when markets have positive returns, investors put in less money today than what that investment should compound to when they make withdrawals in the future. Thus, it should be no surprise that net flows from the household sector have historically been negative over all longer periods of time going back 60 years, while the amount of stock held by the household sector has continued to move higher.

To summarize... the form of distribution really does not matter and buybacks are not evil... the next time you hear someone state buybacks are the cause of the run up in stocks, try replacing the word buyback with dividend.

"Stocks are up because of a huge increase in dividends" sounds a lot less controversial than "stocks are up because of a huge increase in buybacks", though they are both identical signs that the performance has been driven by an improvement in fundamentals and an increase in cash flows.